This examination consists of three essay questions, each of which will be given equal weight in determining grades. Three hours will be permitted for this examination. At the end of the three hours, you must turn in both this set of essay questions and your answers in the original envelope in which this set came.

All answers must be entered in the bluebooks you have been provided (or, for those typing or operating computers, on separate sheets of plain white paper or a computer floppy disk). No credit will be given for anything written on this set of questions.

Pay close attention to the final portion, or "call," of each question. Failure to respond to the matters called for will result in a low score for the question. On the other hand, discussion of matters outside the scope of the call of the question will not receive credit.

Be sure to explain as thoroughly as possible your answers to the questions posed. Your reasoning, discussion, and analysis are often as important as any particular conclusion you reach.

The suggested time limit for each question is one hour. Experience has shown that failure to budget one's time according to this limit can result in a drastic lowering of one's overall grade on this examination.

Unless otherwise instructed, you should assume that:

    all partners described in the questions are individuals;

    all partners and partnerships described in the questions use the calendar year as their taxable year for federal income tax purposes; and

    all partners and partnerships report their income on the cash method for such purposes.

References to "the Code" are to the Internal Revenue Code of 1986, as amended.
 
 

On May 1, 2003, Ella and Frank form a limited liability company named EF. EF is not an "investment company" as described in Section 351(e) of the Code.

Ella contributes to EF land with a fair market value of $200,000 and an adjusted basis to Ella of $85,000; she also contributes $100,000 in cash. Frank contributes no cash or property, but the LLC operating agreement provides that Frank will perform future services for EF in exchange for a 15 percent interest in EF's income, gains, losses, and deductions. The agreement, which has substantial economic effect within the meaning of section 704(b) of the Code, specifies that Ella will be allocated the other 85 percent of all these items. Ella's opening capital account is $300,000; Frank's is zero.

Over the rest of 2003, Frank performs the services specified in the LLC operating agreement. These consist of negotiating the financing and purchase by EF of additional real estate for use in its business, which is retail sales and wholesale distribution. After the real estate is purchased in late 2003, EF plans no further property acquisitions for the foreseeable future; it devotes all of its energies thereafter to retailing and wholesaling activities.

For the taxable year ending December 31, 2003, not counting any transactions between the LLC and its members, EF has $600,000 of gross income (all ordinary) and $400,000 of deductions (also all ordinary). On December 31, 2003, EF pays $30,000 cash to Frank and $170,000 cash to Ella. Documents accompanying the checks characterize both payments as "partnership distributions." After the payments, Ella's capital account is $300,000; Frank's is zero.

What are the federal income tax consequences -- to Ella, Frank, and EF -- of the transactions just described? Be sure to discuss the amount, timing, and character (capital or ordinary) of each item of income, gain, deduction, or loss to each party; and each party's basis in the property or interest which that party holds, at each stage of the transactions.

Discuss.

Rachel, Stan, and Terry are partners in a limited liability partnership, RST. On January 1, 2003, the balance sheet of RST reveals the following:
 

	Assets			Liabilities
	Basis	Fair market value		Basis	Fair market value
Cash	$ 15,000	$ 15,000	Debt	$ 0	$ 0
Inventory	30,000	45,000	Equity
Land (capital asset)	12,000	30,000	Rachel	19,000	30,000
			Stan	19,000	30,000
			Terry	19,000	30,000
			Total equity	57,000	90,000
Total assets	$ 57,000	$ 90,000	Total liabilities	$ 57,000	$ 90,000

Neither the inventory nor the land was contributed by any partner to RST. RST has no assets besides those listed on its balance sheet.

The partnership agreement provides that all income, loss, deduction, and credit are to be shared equally by the partners. This allocation has substantial economic effect within the meaning of section 704(b) of the Code.

On January 2, 2003, Stan retires from RST. On that date, RST pays Stan $8,000 in exchange for his covenant not to compete with RST, and in addition RST distributes to him the land.

What are the federal income tax consequences -- to Rachel, Stan, Terry, and RST -- of Stan's retirement, with and without all available elections? Be sure to discuss the amount, timing, and character (capital or ordinary) of each item of income, gain, deduction, or loss to each party; and each party's basis in the property or interest which that party holds (actually or constructively), at each stage of the actual or deemed transactions.

Explain.

Herb, Iris, and Jo are partners in a general partnership known as HIJ. As of January 1, 2003, each partner has a basis in his or her partnership interest of $100,000, and a capital account of $100,000. HIJ is not an "investment company" as described in Section 351(e) of the Code.

The partnership agreement provides that all items of income, gain, loss, and deduction shall be allocated equally among the partners. The partnership agreements contain the first two of the "big three" requirements for substantial economic effect under section 1.704-1(b)(2)(ii)(b) of the Treasury regulations, and a "qualified income offset" under section 1.704-1(b)(2)(ii)(d) of those regulations.

On January 2, 2003, each of the partners makes an additional capital contribution of $510,000 to HIJ. Iris and Jo make their contributions in cash. Herb contributes to HIJ a valuable building (and a lease, with zero market value, on the underlying land). On the date of the contribution, the building has a fair market value of $510,000 and an adjusted basis to Herb of $240,000. The building is depreciable. For purposes of this question, assume that the partnership will be entitled to depreciate the building using the straight-line method over a 10-year period, with no depreciation conventions, for a depreciation deduction for income tax purposes of $24,000 per year. Assume that if the partnership were purchasing the building in an arm's-length transaction from a stranger, it would be required to depreciate the building using the straight-line method over a 30-year period, with no depreciation conventions.

For the taxable year 2003, other than the depreciation deduction on the building, HIJ's gross income and its deductions just happen to offset each other exactly. The depreciation deduction, however, creates a $24,000 operating loss to the partnership for the taxable year.

What are the federal income tax consequences for 2003 -- to Herb,Iris, Jo, and HIJ -- of the transactions just discussed, with and without any available elections? Be sure to discuss the amount, timing, and character (capital or ordinary) of each item of income, gain, deduction, or loss to each party; and each party's basis in the property or interest which that party holds (actually or constructively), at each stage of the actual or deemed transactions.

Discuss.

Created by:  bojack@lclark.edu
Update:  31 May 03
Expires:  31 Aug 04